December 2002

Accountancy and Society: A Covenant Desecrated

By Abraham J. Briloff

CPAs entered a covenant when they accepted the statutes that created their professional license. There is also the very special franchise, granted to the accounting profession by a three-to-two vote of the SEC at its inception, which requires all registrants to submit financial statements audited by accountants in the private sector rather than by employees of governmental agencies. That special franchise generates revenues amounting to billions of dollars annually.

This covenant was undertaken by the profession and society for a compelling reason: to assure the effective functioning of capitalism catalyzed by the corporate complex, but with an effective system of corporate governance and accountability. Society licensed the accounting profession to oversee that process.

In the day-to-day existence of our citizenry, the private sector of corporate complexes plays a more direct role than the government. The air we breathe, our recreation, mobility, habitats, health, and economic well-being are all affected by decisions of those who control the conduct of corporate enterprises.

Here then is where we meet up with the “power without property syndrome,” described early in the 20th century by Gardner C. Means and later expanded by Adolf A. Berle. Enormous pools of power have been delegated to managers by those who own the resources. To provide assurance to those that have thus delegated their resources to managers, we have built a system of checks and balances, corporate governance, and accountability. Think of a system of concentric rings, with management at the center of corporate power. The first outer ring is the board of directors, whose authority is derived from the shareholders and which is responsible for determining the corporation’s policies, reviewing its operations, and ensuring that the policies are fully and fairly implemented. There then follows the independent audit committee of the board of directors. Those in this role should be aware of why the audit committee has become a vital force in corporate governance and the accountability process. They should be mindful of the standards governing independent audit committees, mandated by stock exchanges and the SEC. Only if the members carry out their role conscientiously and professionally will they fulfill the very special mandate that has been bestowed upon them.

The crucial ring in this system is the independent auditor, responsible for probing the conduct of all aspects of the corporate enterprise on behalf of third parties, the investing public.

This brings us to the ring that represents the nexus of state and federal agencies involved in regulating the corporate complex. The states bring business enterprises into existence by granting corporate charters or licenses as appropriate. The states also bestow licenses for the various professional pursuits, including accountancy and law, that may be involved in the corporate governance and accountability process. The SEC is charged with the administration of the Securities Exchange Acts of 1933 and 1934. It is also the source of Regulation S-X, which governs registrants’ accounting responsibilities and practices.

The next succeeding ring is Congress, which, through its investigative and legislative actions, affects the standards for corporate governance and accountability. Further outward lies the judiciary, principally the federal courts, which through their determinations in civil and criminal proceedings further define the standards for conduct of all those involved in an enterprise.

In addition to accountants, professionals in the fields of law, finance, journalism, and academia are involved in each ring. If this system of interrelated responsibilities fails, we have Enrons and similar market disasters.

Over the past quarter of a century the accountancy profession had been confronted with recurring crises, which have led to Congressional hearings, reports, and even legislation. For example, the Foreign Corrupt Practices Act of 1977 and Title 3 of the Private Securities Litigation Reform Act of 1995 directed the independent auditors of registrants to probe more diligently and aggressively for the possibility of fraud or other accounting irregularities.

The unofficial accounting establishment—the AICPA and what are now the Big Four—responded with “white papers,” sponsored studies, boards, and committees that resulted in lots of sound and fury but in the end signified little, if not nothing. Are we now prepared to study history in the hope of avoiding repeating its mistakes?

Quo Vadis?

This brings me to my response to the question, “Where should we go from here?”

First, I want to reemphasize the cardinal recommendation that I made when I appeared before the SEC on September 21, 2000, in connection with their hearings on auditor independence. To wit: Absolute divestiture; that is, the absences of any “strategic” or other entangling alliances, is para-mount. Then, the SEC should demand that the profession of certified public accountancy rededicate itself to the independent audit as surrogates on behalf of all stakeholders.

The renaissance of the independent audit as a vital social responsibility should prove salutary for relevant research and the teaching of accountancy qua accountancy in the groves of academe.

Going further, I urge the SEC or its Public Company Accountancy Over-sight Board to develop a registry of firms that have fully committed themselves to the independent audit of SEC registrants, consistent with the standards set out above. The SEC or the PCAOB would then be in the position to proceed overtly to impose sanctions on or even delist firms that fail in this undertaking.

The independent auditor should always proceed as a forensic auditor in the wake of an accounting disaster. For example, about four years ago I had occasion to analyze the report prepared by Arthur Andersen as the forensic auditor in the wake of the discovery of the fraud at CUC International prior to its merger into Cendant in late 1997. I congratulated Andersen on the ways in which it ferreted out the perversity perpetrated by the financial people at CUC and spelled out the errors of omission and commission on the part of Ernst & Young, CUC’s auditors. Then, just as I brought my analysis and commentary to a close, along came Sunbeam, where Andersen, as the independent auditor, erred very much like E&Y had at CUC.

The auditors know what they need to do to produce a product that the investor can rely on. They need not become adversaries to the groups represented by the rings inside them, but they should seek a standard of truth and objectivity.

I would then look for change to conform the responsibility for the determination of the financial statements to what is presently presumed by society generally, including even sophisticated investors. The community of users of statements presumes that they have been determined by the certifying independent auditor. The actuality is the statements are really those of management, with respect to which the auditor opines that they are consistent with GAAP.

The resulting auditor’s report, in the form of words and numbers characterized by clarity, logic, and integrity, should convey a description of economic reality as closely as current communications, economics, and accountancy allow.

If We Should Fail …

What if the required changes are not implemented promptly and effectively? If we find ourselves deadlocked and our economic society continues to be vulnerable, then, despairingly, I would reintroduce the proposal I advanced to FASB two years ago at its hearings on business combinations: Abort the present requirement that such financial statements carry the imprimatur of independent CPAs, because the major firms that are principally responsible for those audits are no longer firms of CPAs, nor are they as independent as they are perceived to be by the financial community.

If this proposal were implemented, the determination and implementation of the accounting precepts and practices that best reflect the financial condition and operations of the enterprise would become the sole responsibility of management, which is essentially the prevailing truth. The public’s view of the independent audit would be revealed as a myth.

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